Tuesday, 6 August 2013

Eurozone survival: transfer union, yes. Fiscal union, no

There is no sustainable monetary union without fiscal and eventually political union.

The argument goes like this: when there is a negative economic shock impacting some regions of a monetary union much more severely than others (an asymmetrical economic shock), the negatively impacted ones will have no autonomous monetary policy to respond to the shock. They will have no currency of their own to devalue, increase competitiveness and eventually restore economic growth to overcome their problems. Therefore, a fiscal union is needed to transfer resources from the "strong" to the "weak" countries of the union in such circumstances - this being the only way to restore growth in the latter. And since a democratic system has to comply with the principle of "no taxation without representation", a fiscal union cannot exist without a political union backing it. 

In the case of the Eurozone, this would mean:

a) Issuing Eurobonds (fiscal union)


b) Transferring competences from national parliaments and governments to a directly elected Eurozone parliament and government. The end of Eurozone national states as we know them and the birth of an Eurozone superstate (political union)

And here is where the problems really start: the German government and German citizens (via a referendum) would even most likely agree to the introduction of Eurobonds as long as it was accompanied by a political union of the Eurozone. 

But who else is ready for a political union of the Eurozone? Spain? Italy? France? The answer can only be: almost no one else. None of the other three Eurozone large countries. And certainly not the Grande Nation - for the French establishment, Paris is still the centre of the world.

Given this set of circumstances, the logical and straightforward conclusion is that the Eurozone will fall apart and implode. This is the reasoning behind the doom & gloom views about Eurozone's future often found in the Anglo-Saxon press and investment circles.

The Anglo-Saxon view of the (Eurozone) world is however likely to be proven wrong.

A transfer union from the surplus to the deficit countries is undoubtedly necessary to solve the current Eurozone crisis and for a sustainable monetary union. However, the Anglo-Saxon approach to Eurozone's crisis resolution is missing one important point: you can have a transfer union without a fiscal union. The transfer of funds from the surplus to the deficit countries can be done via the private sector:

1. Debt restructuring across the board for both public and private debt in the deficit countries.

2. The then unavoidable recapitalization of the Eurozone banking sector done via debt-to-equity swaps: insured depositors are protected, shareholders wiped-out, unsecured creditors become the new bank shareholders (if this is not enough, Eurozone public monies can then and only then be used to close the remaining recapitalization gap). This way breaking the vicious circle between the national banking systems and the respective sovereign.

3. With excessive debt - in both the public and private sector - eliminated and the Eurozone banking system well recapitalized, economic growth will come back. Swiftly. Eurozone's financial crisis will be solved for good.

Given that the deficit countries' and Eurozone banks' creditors are mainly citizens of the surplus countries (they are the ones with the savings that financed directly and indirectly - via the banking system - the deficit countries), this mechanism will in practice lead to a transfer of funds from Eurozone's center to the periphery. From the "strong" to the "weak" countries.

So, for those who like to frame the issues at stake in the Eurozone in terms of Germany against the rest, the message couldn't be clearer: relax. Germany will pay the bill. But it will be the German investor, who freely decided to invest in the periphery, that will pay. Not the German taxpayer. Which means that for the German taxpayer, always very much worried about the prospect of being forced to bail-out the entire Eurozone, the message couldn't be clearer either: relax.

The private transfer union mechanism just described, can also be called differently: a banking union (with a minimal degree of fiscal union - public monies necessary to close the Eurozone banking sector's recapitalization gap). And it is, roughly speaking, what has been agreed to be implemented by the European council of finance ministers in their 27 June 2013 meeting, with the directive to be approved by the European parliament by the end of 2013 (http://register.consilium.europa.eu/pdf/en/13/st11/st11228.en13.pdf)

In summary, there are good and bad news coming out of the Eurozone:

Good news: old Europe is about to implement a market economy compliant private sector transfer mechanism to break the vicious circle between national banking systems and their respective sovereigns. And in the process solve its financial crisis. It is highly unlikely that the Eurozone will fall apart. The Eurozone is highly unlikely to collapse.

Bad news: with heavy losses being imposed on Eurozone banks' shareholders and unsecured creditors, massive volatility will return to financial markets as soon as Eurozone's debt and bank sector restructuring starts. The ECB will have to step in to provide banks with liquidity during the restructuring process.

Good news amid the bad news: once the Eurozone debt and bank restructuring process is over (9-12 months after its start, if done in a coordinated manner), markets will recover fast.

This leaves us with one question: who said that old Europe is not an exciting place to live in?

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